euro-zone debt crisis

The euro-zone debt crisis was a period of economic uncertainty in the euro zone beginning in 2009 that was triggered by high levels of public debt, particularly in the countries that were grouped under the acronym “PIIGS” (Portugal, Ireland, Italy, Greece, and Spain).

Prelude to the crisis

The debt crisis was preceded by—and, to some degree, precipitated by—the global financial downturn that soured economies throughout 2008–09. When the “housing bubble” burst in the United States in 2007, banks around the world found themselves awash in “toxic” debt. Many of the so-called subprime mortgages that had fueled the tremendous growth in U.S. home ownership were adjustable-rate mortgages that carried low “teaser” interest rates in the early years that swelled in later years to double-digit rates that the home buyers could no longer afford, leading to widespread default. Frequently, mortgage lenders had not merely held the loans but sold them to investment banks that bundled them with hundreds or thousands of other loans into “mortgage-backed” securities. In this way, these loans were propagated throughout the entire global financial system, causing overleveraged banks to fail and triggering a contraction of credit. With banks unwilling to lend, the housing market declined further as excess inventory from the bubble years combined with foreclosures to flood the market and drive down property values.

Around the world, central banks stepped in to shore up financial institutions that were deemed “too big to fail,” and they enacted measures that were designed to prevent another, larger banking crisis. Finance ministers of the G7 countries met numerous times in an attempt to coordinate their national efforts. These measures ranged from cutting interest rates and implementing quantitative easing—an attempt to increase liquidity through the purchase of government securities or bonds—to injecting capital directly into banks (the method used by the United States in the Troubled Asset Relief Program) and the partial or total nationalization of financial institutions.

The first country other than the United States to succumb to the financial crisis was Iceland. Iceland’s banking system completed privatization in 2003, and subsequently its banks had come to rely heavily on foreign investment. Notable among these institutions was Landsbankinn, which offered high-interest savings accounts to residents of the United Kingdom and the Netherlands through its Internet-based Icesave program. Iceland’s financial sector assets ultimately exceeded 1,000 percent of the country’s gross domestic product (GDP), and its external debt topped 500 percent of GDP. In October 2008 a run on Icesave triggered Landsbankinn’s collapse. When Iceland’s government announced that it would guarantee the funds of domestic account holders but not foreign ones, the news rippled through the financial systems of Iceland, the Netherlands, and the United Kingdom. Nearly 350,000 British and Dutch Icesave depositors lost some $5 billion, and the ensuing debate over who would compensate them caused a diplomatic rift between the three countries that would take years to heal.

Within weeks of Icesave’s failure, Iceland’s massively overleveraged banks had been virtually wiped out, its stock market had plummeted roughly 90 percent, and the country, unable to cover its external debts, was declared to be in a state of national bankruptcy. The Icelandic government collapsed in January 2009, and incoming prime minister Jóhanna Sigurðardóttir imposed a series of austerity measures to qualify for bailout loans from the International Monetary Fund (IMF). What separated Iceland from the debt crises to come, however, was its ability to devalue its currency. Iceland was not a member of the euro zone, and its currency, the krona, was allowed to depreciate dramatically against the euro. Inflation subsequently skyrocketed and GDP sharply contracted, but real wages began a slow recovery in 2009.

The crisis unfolds

Since the creation of the euro zone, many member countries had run afoul of the financial guidelines laid forth in the Maastricht Treaty, which had established the European Union (EU). These requirements included maintaining annual budget deficits that did not exceed 3 percent of GDP and ensuring that public debt did not exceed 60 percent of GDP. Greece, for example, joined the euro zone in 2001, but it consistently topped the budget deficit limit every year. However, the lack of any real punitive enforcement mechanism meant that countries had little incentive to abide by the Maastricht guidelines. Although each of the PIIGS countries arrived at their moments of crisis because of different factors—a burst housing bubble in Spain, a shattered domestic banking sector in Ireland, sluggish economic growth in Portugal and Italy, and ineffective tax collection in Greece were among them—all of them presented a threat to the survival of the euro.

The EU response to the crisis was spearheaded by German Chancellor Angela Merkel, French Pres. Nicolas Sarkozy, and European Central Bank (ECB) president Jean-Claude Trichet (succeeded by Mario Draghi in October 2011). Germany, as Europe’s largest economy, would shoulder much of the financial burden associated with an EU-funded bailout plan, and Merkel paid a domestic political price for her commitment to the preservation of the EU. Billions of dollars in loans from the EU and the IMF would ultimately be promised to ailing euro-zone economies, but their disbursement would hinge on the willingness of the recipients to implement a wide range of economic reforms.

Timeline of key events in the European sovereign debt crisis

2009

• October
  • In a snap election called by Prime Minister Kostas Karamanlis of the New Democracy (ND) party, Greek voters express their dissatisfaction with a sluggish economy by emphatically supporting the opposition Panhellenic Socialist Movement (PASOK). PASOK leader George Papandreou is sworn in as prime minister.
• November
  • Papandreou’s administration uncovers evidence that misleading accounting practices had concealed excessive borrowing by the preceding ND government. Based on corrected figures, the Greek budget deficit for the year more than doubles to 12.7 percent of GDP.
• December
  • Ratings agencies Fitch and Standard & Poor’s downgrade Greece’s credit rating to below investment-grade status. The Greek stock market tumbles, and the Papandreou administration reveals that Greece’s sovereign debt burden now tops €300 billion (about $440 billion). This puts Greek debt at 113 percent of GDP, almost double the amount allowed under Maastricht.
  • Having spent billions to shore up its beleaguered banks, Ireland implements austerity measures that include increasing the minimum eligibility age for pensioners from 65 to 66.

2010

• February
  • Papandreou unveils an austerity plan aimed at reducing Greece’s budget deficit by almost 10 percent by 2012. It includes a freeze on public-sector wages and a variety of tax increases. The EU endorses the plan, but protests and wildcat strikes sweep the country.
  • Spanish Prime Minister José Luis Rodríguez Zapatero, facing an economy rocked by plunging property values and soaring unemployment, announces an austerity plan that would increase the retirement age from 65 to 67. Labour unions lead mass demonstrations against the change, but after almost a year of negotiations the plan is approved in January 2011.
• March
  • Papandreou proposes a new financial package for Greece that includes additional public-sector pay cuts and a 2 percent sales tax increase. He meets with German Chancellor Angela Merkel, French Pres. Nicolas Sarkozy, and U.S. Pres. Barack Obama but maintains that Greece is not in need of a bailout. By the end of the month, leaders of the euro zone and the IMF have agreed upon a deal whereby both parties would provide financial support for Greece.
• April
  • The 2009 Greek budget deficit is revised up to 13.6 percent, and Greek government bond yields skyrocket as Standard & Poor’s downgrades their credit worthiness to junk status.
• May
  • On May 2 Papandreou, the IMF, and euro-zone leaders agree to a €110 billion ($143 billion) bailout package that would take effect over the next three years. In response, some 50,000 people take to the streets of Athens to protest the additional budget cuts mandated under the terms of the deal. Three people are killed when the demonstrations turn violent.
  • Responding to rising Portuguese bond yields and continued volatility in the value of the euro, the EU and the IMF create a €750 billion ($1 trillion) emergency fund to shore up flagging euro-zone economies.
• June
  • On June 8 the euro closes at $1.19, its lowest rate of exchange against the U.S. dollar since March 2006.
• July
  • The EU releases the results of “stress tests” conducted on 91 European financial institutions. Of the banks that were tested, seven did not maintain the minimum amount of ready capital required by examiners.
• September
  • Ireland’s central bank announces that the cost of bailing out Anglo Irish Bank, nationalized by the Irish government in January 2009, could reach as much as €34.3 billion ($46.6 billion). This pushes Ireland’s budget deficit to 32 percent of GDP.
• November
  • After months of delay, Ireland’s government officially applies for bailout funds from the EU and the IMF. Embattled Irish Prime Minister Brian Cowen submits a harsh austerity budget and promises to call a general election in 2011. Within a week an €85 billion ($113 billion) rescue package is approved by European leaders.

2011

2012

2013

2014

2015